Question

Suppose that income is $45, the price of snickers is $1.50, and the price of kit kats is $3, you buy 12 snickers and spend the rest of your income on kit kats. When the price of snickers increases to $2.50, you now buy 6 snickers. Illustrate this change and both the income and substitution effects graphically.

Answer 1

At $1.5, the amount spent on 12 snickers is 12 × 1.5 = $18

The amount spent on Kit Kat is 40 - 18 = $22

Amount spent on 6 snickers at $2.5 is $15.

The amount spent now on kit Kat is $30.

The increase in the price of the snickers leads to a pivot in the budget line as shown in the figure. The income effect of the price increase of snickers causes the consumer to spend less on both goods since the real income gas declined. The substitution effect on the other hand makes one substitute snickers with kit Kat due to relative price change. The shift in the indifference curve is shown in the figure. The income effect is indicated by the parallel shift of the budget line towards left while substitution effect is shown by a pivot in the budget line.